The Social Cost of Carbon: Implications for Maine (Part II)

My most recent blog post, “The Social Cost of Carbon: Implications for Maine (Part I),” went into some of the details behind calculating the social cost of carbon – a number that is used to illustrate the economic damages anticipated by climate change and therefore linked to carbon dioxide emissions.
This blog post will be a bit more policy oriented. Once we arrive at a social cost of carbon, what do we do with it? How can we use it to reduce the amount of carbon that’s emitted into the atmosphere?

Essentially, there are three policy options to reduce climate change. One is what economists like to call “command and control.” This is standard regulation – where each company or industry is given a standard beyond which they are not allowed to pollute. If they are found to have polluted beyond that standard, they are then (typically) fined a certain amount.

The second and third option are what economists call “incentive-based regulation.” Rather than give companies or industries a hard and fast limit, this type of regulation gives the regulated community an incentive to reduce emissions. The incentive could be in the form of a subsidy for each unit of pollution reduced, or, alternatively, a tax system could be put in place. In that case, the firm’s incentive to reduce pollution is the avoided tax on each unit. (From an economic perspective, there is actually no difference between a tax and a subsidy when it comes to determining the “efficient level” of pollution. From a political perspective, of course, there is a huge difference.)

A third option is to implement a trading scheme. The idea is simple: firms are distributed a certain number of permits or “rights” to pollute. (The permits could be initially distributed free of charge, or the permits could be auctioned off.) Firms that could then reduce a unit of pollution more cheaply than the permit price would do so, and sell the unused permit on the market to other firms that have a more difficult time reducing pollution. The firm’s incentive to reduce is the price that they get from selling their permit. Creating a market like this is not without its difficulties, and markets for pollution have met with varying degrees of success. One pollution market close to home is RGGI, the Regional Greenhouse Gas Initiative, which is the topic of one of my earlier blog posts. The revenue gained from auctioning off the permits goes to energy-saving initiatives.

One of the major difficulties in both of these is to set the “right” price – too low, and not enough firms will reduce their emissions; too high, and it can create political dissatisfaction and a drag on the economy. (A side note: unbridled carbon emissions are already creating havoc with Maine’s economy – but that will be the topic of a later blog post.)

A second major difficulty (what I like to call the “liberal’s paradox) is that implementing a carbon price will necessarily be regressive – the burden of the tax will be felt disproportionately among lower-income households. A price on carbon – whether it’s a tax or a permit system – will raise the price of carbon-intensive goods and services, such as fossil fuels and conventionally-generated electricity. Low-income households spend a higher percentage of their income on fuel and electricity than do higher-income households. What to do? It turns out that what you do with the revenue from the tax (“revenue recycling”) can moderate or even negate the regressivity of the tax.

The think tank Resources for the Future (RFF) has published a series of articles addressing this very topic. I’m going to address three possibilities for revenue recycling. Two of them have to do with reducing taxes on other things – shifting the burden from taxing economic “goods” (like income and labor) to taxing economic “bads” (like pollution). (After all, if part of the point of a tax is to alter behavior, why tax good things like income and employment?) The third has to do with returning the revenue directly to the people. So I’m going to focus on three alternatives: tax carbon, but lower the tax on labor income; tax carbon, but lower the tax on capital income; and tax carbon, but return the revenue to the people in the form of a dividend or a lump-sum rebate.

RFF analyzed these three alternatives for their impact on different income groups to see which groups were “better off” after the tax and revenue-recycling scheme, and which were “worse off.” (It’s important to note that RFF did not analyze the effects of reducing carbon emissions – the primary goal of the tax, after all! – on the welfare of each of these groups. It’s well-known that low-income populations are the most sensitive to climate change, and therefore the group most likely to benefit from a reduction in greenhouse gas emissions.)

What they find, summarized, is this: the labor tax recycling scenario found that almost all groups ended up slightly worse off (the groups’ welfare or well-being declined by less than a half of a percent), but that the highest income group ended up with the biggest decline in welfare. The capital tax recycling scheme benefited the highest income group, while generating a reduction in welfare for all other income groups of less than one percent. And the lump sum rebate scheme benefited the lowest income group by more than three percent, while harming the highest income group by almost two percent. From an efficiency perspective, the capital tax recycling scheme is the most efficient (that is, the policy that “distorts” the economy the least).

I’ll replicate RFF’s graphic here:

Source: 2015. Williams, Roberton C., Burtraw, Dallas, and Morgenstern, Richard. “The Impacts of a US Carbon Tax across Income Groups and States.” Washington, DC: Resources for the Future).

Why such differences? Largely, it has to do with where individuals earn their income. Generally speaking, high-income households get a larger percentage of their income from capital (stocks, bonds, and property), while middle-income people rely more heavily on income from labor. Low-income people typically get a larger percentage of their income from transfer payments, which not only include food stamps and unemployment insurance but also Social Security. That explains why lowering the tax on capital would exacerbate the regressiveness of the carbon tax, while lowering the tax on labor would be slightly progressive.

What about here in Maine? I wasn’t able to get data directly for Maine, but only for New England as a whole. As it turns out, all the schemes end up diminishing the welfare of New England residents, but the lump-sum rebate actually performs the worst. Why? The answer mainly has to do with the fact that, overall, New Englanders receive a relatively high percentage of their income from capital as opposed to labor.

How about Maine, though? Is that the case? Looking at the Bureau of Economic Analysis for 2015, I noticed that Mainers as a whole received about 60% of their personal income from wages and salaries. An additional 22.5% comes from personal transfer receipts, which include Social Security benefits, medical benefits, veterans’ benefits, and unemployment insurance benefits. (By far the majority of these personal transfer receipts are retirement income and income from other benefits, excluding unemployment insurance benefits and income maintenance programs such as general assistance.) A little less than 18% comes from capital and property income.

By contrast, Connecticut receives about 66% of its personal income from wages and salaries, 12.8% from transfer payments, and over 21% from capital and property. This implies that lowering the tax on capital would not benefit the average Mainer as much as the average person from Connecticut – but without doing the calculations, I can’t be sure whether the labor tax recycling scheme or the lump sum dividend would be more or less welfare changing.

Of course, the election on November 8 may have made this a moot point. Passing a carbon tax (or fee, as some like to call it) has had a difficult time in the past, and the election of Donald Trump has made that possibility more remote. Any action now is likely to arise at the state level – which is why state level analysis is crucial. Climate change will likely have a disproportionate effect on those who are least able to protect themselves. Any actions to mitigate climate change should not increase the injury.